Red-hot energy sector requires cool thinking

Your Funds

When performance numbers come in for the first half of the year, chances are that at least eight of the top 10 stock mutual funds will be in the energy and natural resources sector.

That will get a lot of people wondering whether they should dive into an energy sector fund too.

The real answer depends less on the market and the energy companies than on the personality, temperament and portfolio of the investor involved.

Buying any asset after it heats up is risky business, the classic recipe for a "buy high, sell low" disaster.

Energy funds today are reminiscent of two similar cases from the recent past.

Most recently, at the end of 2002, real estate funds had completed several years of big gains while the stock market as a whole had come crashing down. And just a few years before that, no one can forget the end of the bear market, when investors loaded up on technology funds, only to get slaughtered when the bubble burst.

Both situations are relevant to people thinking of buying into energy funds today.

By the time many investors caught on to real estate funds - which typically invest in commercial ventures - there was a legitimate concern that buyers were simply chasing performance. That was balanced by the idea that many investors had no commercial real estate in their portfolio; real estate was such a good counterbalance during the bear market that it was easy to make the case that buying in was an "asset allocation decision."

Investors justified the move by saying they weren't chasing performance, but rather making sure that a particular asset class was properly represented in the portfolio.

(Of course, if the investors sold the first time their real estate investment trust fund burped, they were proving that it had been a performance-chase after all.) By comparison, in 2000, investors loaded up on tech because they couldn't foresee a scenario where it would go in the tank.

Investors buying tech funds already had a big slug of tech in their other growth and value funds. That technology overdose got people high in good times, but killed them when the market turned.

"Today's energy investor resembles the tech investor of the late 1990s - who was overweight in technology, thinking the run was never going to end," says Jeff Tjornehoj, research analyst for Lipper Inc. in Denver. "But the energy business today does not resemble tech from 2000. Energy companies are making money, they have proven reserves, and they are paying dividends. ... That means the outcome will not be the same - there won't be a total collapse - but it doesn't mean that energy automatically justifies how crazed people are for it right now."

Like tech - and unlike real estate - energy also is a staple of many ordinary growth funds. Pick any number of big-name funds like Fidelity Contrafund (FCNTX) and Janus Growth & Income (JAGIX) and you will find more than 10 percent of the portfolio in energy. Some funds, like Artisan Mid-Cap Value, have more than 20 percent of their assets in energy.

That means that an ordinary portfolio might have 10 percent of its stock assets in energy, before an energy sector fund ever enters the picture.

"Lots of growth funds have energy," says Russel Kinnel, director of mutual fund research at Morningstar Inc., "and the last time all these funds had a lot of money committed to energy, it was in Enron. This current obsession with energy won't turn out that badly, but it does show why you want to be very careful."

Indeed, energy sector funds topping the short-term performance charts is a clear sign of dangerous volatility, as chart-toppers often wind up at the bottom in a hurry.

"The Vanguard Energy fund [VGENX], was up 19 percent for the year in March, and dropped close to half of that a few weeks later," says Dan Wiener, editor of The Independent Adviser for Vanguard Investors newsletter. "The investor who gets into something as volatile as energy needs to understand that if their timing is bad, they can get their head handed to them."

No one is suggesting that energy funds will lose their momentum overnight. Barring a sudden drop in oil prices, most experts believe the short-term outlook for natural resources and energy companies is pretty good.

But this is no time to mistake a good run for a "can't miss."

Charles Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, Mass. 02025-0070.